The Private Offering Exemptions

The duty to update and the duty to correct

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  3 issues in this case
  
  1. 
     Does the co have a duty to update optimistic future plans if it turns out that the plans won’t pan out
     
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       There is a duty to update, but not for simply expressed hopes.
       
  2. 
     Does the co have the duty to disclose alternative plans if under consideration
     
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       Depends
       
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       Here, it is the case that noe disclosing these other techniques of raising cash made original statements misleading.
       
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       So, you have to look to whether the omitted info is material
       
  3. 
     Is the co responsible for statements in newspapers if made by an anonymous person?
     
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       You have to plead fraud with particularity. You can’t allege fraud when you can’t point to the person who made the statement
       

INSIDER TRADING – possible to make money based on the semi-strong form of efficiency  stock prices instantaneously reflect all publicly available info relevant to the value of the traded stocks

Rule 10b-5 – primary regulator of insider trading

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  a corp insider who has material non-public info about the enterprise is under a duty either to abstain from trading or first to disclose the non pub info
  

In defining when insider trading is fraud prohibited by Rule 10b-5, the Sup Ct focused on silence by one who has such a state law duty to disclose or abstain. This liability is sometimes described as classic or traditional insider trading. This sec describes extensions of that liability beyond the classic group, first addressing those who obtain info from the classic insider and are covered by the extension of that insider’s duty. This group includes

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  those who receive info from the insider or the corp for an appropriate purpose (constructive or temporary insider) and
  
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  those whom the insider tips for an improper purpose (tippee liability)
  

The second category is somewhat broader based either

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  on the duty owed to a non-trading party (misappropriation)
  
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  or one who receives info in the context of a tender offer (Rule 14e-3)
  

Chiarella

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  Def’s use of info was not a fraud under 10b unless he was subject to an affirmative duty to disclose it before trading  without a duty to disclose, merely having the info and acting upon it doesn’t give rise to liability
  
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  When you don’t have a duty to disclose, you can’t partake in fraud
  
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  A duty to disclose exists when you have a relationship of trust and confidence
  
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  10b5-1  You have to trade on the basis of the material non public info: in order to trade on the basis of the info – the person must be aware of the material non public info when they traded
  

You have to trade on the basis of the material non public information. The question is then, what does this mean? Look at Rule 10b5-1 – prior to the adoption of this rule, there was a split bw what it meant to trade on the basis of the info. If you possess the info as an insider, it’s enough. Others say you actually have to use the information. On the one hand, I may be in possession, but if I don’t use it, then I shouldn’t be punished. On the other hand, it’s hard to prove if you used the info or not. Second, you may not think you used the info, but subconsciously you may have used it.

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  Affirmative defenses – clause (c )
  
  1. 
     if the person before becoming aware of the info either
     
  2. 
     entered into a binding K to buy or sell or
     
  3. 
     instructed another to buy or sell or
     
  4. 
     had adopted a written plan to buy or sell, then you will be deemed not to have traded on the info
     

Tippee liability and constructive insiders

Dirks

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  Test
  
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    Tippee assumes a fiduciary duty to the SHs not to trade, only when the insider has breached his fiduciary duty to the SHs by disclosing to the tippee, and the tippee knows or should have known that there was a breach. Tippee liability is derivative of the tipper breach. We can tell if there is a tipper breach if the tipper receives some sort of benefit from the breach. The benefit can be either direct or indirect. This includes tip to a relative or friend – cts will see this as the tipper actually trading and making a gift to the relative or friend.
    
  • 
    If the tipper has no personal gain, then there is no tipper breach of fiduciary duty, and if there is no tipper breach of fiduciary duty, there can be no tippee liability
    
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  Footnote 14: Constructive insiders – under certain circumstances, lawyers, consultants, accountants, underwriters will be treated as an insider
  

Misappropriation Theory

O’Hagen

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  Classic insider trading – constitutes fraud or deception bc the insider owes a fiduciary duty to the corp and the SHs
  
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  O’Hagen had nothing to do with the target; he was working for the bidder, so he owes no duty to target SHs
  
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  The misappropriation theory fills the gap – a person commits fraud in connection with a sec transaction and violated 10b and 10b-5 when he misappropriates confidential info for securities trading in breach of a duty owed to the source of the info (not to the parties on the other side of the trade).
  
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  2 part reasoning
  
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    fraud-duty discussion
    
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      Yes there is a fraud. Fraud is an aspect of insider trading. Fiduciaries undisclosed use of a principal’s info defrauds the principal’s use of the info
      
  • 
    Is the fraud in connection with the sale or purchase of securities?
    
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      The in connection requirement was satisfied. The ct says that the fraud is consummated, not when the fiduciary gets the info, but when, without disclosing the info to the principal, the fiduciary uses the info to buy and sell securities.
      

What is the nature of the duty to the source? What is the scope of that duty?

SCOPE OF THE DUTY

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  10b5-2 – the requisite duty of trust and confidence exists for purposes of the misappropriation theory when
  
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    the person agrees to maintain the info in confidence.
    
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    When the person sharing the info have a history, pattern or practice of sharing confidences, such that the recipient knows or should know that there is an expectation of confidentiality
    

When info is shared with parent, spouse, child, or sibling, unless the recipient can show that there is no expectation of confidentiality

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  discussion about Rule 14e3 – under the Williams Act (sets up a bunch of rules and provisions by which tender offers are made) – it prohibits trading on the basis of material non public info in regards to tender offers; this says nothing about a duty breach. The question is whether a rule that doesn’t requires a duty breach is beyond the SEC’s authority – if there is no duty breach, then there is no fraud, and SEC should only be prohibiting fraud and deceit. Holding – this doesn’t run afoul of the SEC’s authority, you don’t need a duty breach. The Williams act is about informed SH choice, not necessarily about fraud, and a rule that allows people to trade on insider info makes it hard for investors to trade on insider info.
  

Insider Trading (few words on it)

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  to show the limits of the misappropriation theory
  
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  Let’s assume that O’Hagen’s law firm gave him the information to trade with as a bonus, would that be a problem under the misappropriation theory? The firm may be liable under a tipper type of theory. Firm may be misappropriating the info from the co. But, what about O’Hagen? To have liability under the misappropriation theory, you have to have fraud. But, is there any fraud when the source of the info gives you permission to use the info? It looks like there is no breach of a duty bc there is no misappropriation bc he got permission to use it.
  
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  But, we could make the argument that the duty was owed to the co not the firm. In that case, he misappropriated it.
  
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  What if he gets the info and he tells the co he’s going to trade it, but they say he can’t, but he does anyway? There is no misappropriation bc he disclosed it to the source. For there to be fraud under 10b-5, there has to be some non-disclosure to the source of the info.
  

Really, fiduciary duty is only owed to stock holders, not bond holders.

10b-5(2) – this solved the confusion over what constitutes the requisite relationship for misappropriation

a duty of trust and confidence for the misappropriation theory whenever

1) a person agrees to maintain the info in confidence

2) the person sharing info (source and recipient) have a history pattern or practice of sharing confidences such that the recipient knows or should know that there is an expectation of confidence

3) when a person shares info with parent child or sibling, unless the recipient can show that there was no expectation of confidence
Non-Insider trading violations

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  this is 10b-5, but not insider trading
  
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  various elements of 10b-5, non-insider trading:
  
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    have to have standing  have to have been a buyer or seller, and fraud has to be in connection with a transaction  have to have bought or sold
    
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    You have to have some sort of material misstatement or omission
    
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    Scienter
    
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    Reliance
    
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    Causation
    

Scienter – another aspect of a 10b-5 claim – intent to deceive, manipulate, or defraud

Ernst and Ernst v. Hochfelder – in private transactions under 10b-5, you have to have scienter

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  10b-5 doesn’t extend to negligent behavior
  
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  Scienter refers to a mental state embracing
  
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    the intent to defraud, deceive, or manipulate.
    
  • 
    Also covers recklessness – recklessness is a type of intent
    
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      Highly unreasonable omissions or misrepresentations, which is an extreme departure from ordinary care, which is known to the def or should have known
      
      • 
        Carelessness approaching indifference
        
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  Scienter doesn’t mean that the def has an intent to deceive investors, it is enough that the def is aware of the true state of affairs and knows that there is a good chance that the investor will be mislead.
  

Reliance and Causation

Basic v. Levinson

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  reliance and fraud on the market theory
  
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  Fraud on the market theory – based on the hypothesis that, in an open and developed securities market, the price of a co’s stock is determined by the available material info regarding the co and its business. Misleading statements will therefore defraud purchasers of stock even if the purchasers do not directly rely on the misstatements. The causal connection bw the defs’ fraud and the Ps’ purchase of stock in such a case is no less significant than in a case of direct reliance on misrepresentations.
  
  • 
    FOTMT is a rebuttable presumption
    
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      Can rebut by showing that the market makers (guys who agree to buy and sell the securities – being the other guy to the transaction) or those who effectively set the price were privy to the truth  truth on the market
      
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      Can also rebut by showing that the P would have bought or sold regardless if they knew the truth or not  they weren’t relying on the integrity of the market to buy or sell.
      
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  Reliance is an element of a 10b-5 cause of action  provides the requisite causal connection bw a def’s misrepresentations and a P’s injury. Bc most publicly available info is reflected in market price, an investor’s reliance on any public material misrepresentation, therefore, may be presumed for purposes of a Rule 10b-5 action.
  
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  ­Causation – the P’s economic loss was caused by the def’s wrongful conduct. If the P is able to show that the def’s wrongful conduct caused such a loss this will tend to est the in conneciton with requirement bw the def’s conduct and the P’s purchase or sale of securities.
  

The cts have established that with regard to private recovery for the violation of Rule 10b-5, a properly stated cause of action must est

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  the scienter of the def
  
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  the materiality of any misrepresentation or omission by the def
  
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  the extent of actual reliance by the P on the def’s statements, and the justifiability of the reliance, frequently translated into a requirement of due diligence by the P.
  

REG FD – addresses selective disclosure, for reporting cos

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  This is the most recent way SEC has tried to combat insider trading
  
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  About securities analysts  gets info into the market that might not otherwise get there.
  
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  Cos would selectively disclose info to their analysts – give them a heads up before anyone else would know. These guys would go and write their reports and advise their clients.
  
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  Why weren’t they subject to liability? Well, there is no showing that there was personal benefit to the insider; therefore no breach of fiduciary duty. Arguably they weren’t getting any benefit bc they were doing their job
  
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  This is the problem that Reg FD tried to address. Even if there was no insider trading, and there were no insider trading concerns, there was this notion that selective disclosure was unfair bc there was no longer a level playing field.
  
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  Selective disclosure results in the loss of investor confidence.
  
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  Reg FD prohibits selective disclosure to individuals who are likely to trade on the info.
  
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  BACKGROUND POLICY
  
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    Unfair to small investors – they lose confidence in the system
    
  • 
    Issuers could use selective disclosure strategically. I’ll give it to you if you write up something good about the co – if you give me a buy rating. It’s easy to use this strategically.
    
  • 
    Selective disclosure has some benefits
    
    1. 
       When we talk to the analyst we get info to the marketplace
       
    2. 
       Get the info out there slowing, get the stock price moving slowly, may not want to disclose publicly bc you don’t want to get it to the competitors. So, it does encourage getting the info out there rather than not disclosing at all
       
    3. 
       Notion that by selectively disclosing to those who understand and appreciate the significance of the info avoids over reactions of the marketplace  avoid the over-reaction
       
    4. 
       If you don’t allow selective disclosure, some cos may not disclose anything at all – this isn’t good. So, may want selective disclosure
       
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         Some cos don’t want to disclose info publicly.
         
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         The prohibition on selective disclosure only applies to material info.
         
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         But, there may also be a deterrence to disclosing immaterial stuff that may be good to have in the marketplace bc of the uncertainty of what is material and what is not.
         
    5. 
       The disadvantages may outweigh the advantages.
       
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  unintentional disclosure – promptly disclose publicly
  
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  intentional disclosure – simultaneous disclosure
  
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  who is covered? Domestic reporting cos under the 34 act, or any person acting on behalf of a reporting co (CEO or PR guy or someone like that). Mid level EEs don’t fall within the scope of coverage. Reg FD doesn’t cover when some person in a place of confidentiality – the issuer isn’t on the hook the person who discloses is on the hook.
  
  • 
    disclosures of an IPO aren’t covered bc not a reporting co yet.
    
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  Same def of materiality
  
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  Mosaic theory – give little bits of immaterial info for the analyst to put together something that is material. What kind of info would be considered mosaic info? Info like a Latino person was fired. The analyst can put it together that this was the 4^th Latino person fired, so maybe there will be a discrimination charge.
  
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  There are things that you have to disclose:
  
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    Earnings, mergers, acquisitions, new products, discoveries, change of control, change of auditor, events regarding issuers stock, bankruptcy…. (this is all listed somewhere)
    
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  Reg FD only covers disclosures to certain enumerated persons
  
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    Sec market professionals
    
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    Sec holders if it is reasonably likely they will trade on the info
    
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  Exemptions
  
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    Persons in positions of confidence
    
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    Persons who agree to maintain confidence (by it’s terms Reg FD doesn’t have a carve out for private placement – so you get these guys to sign an agreement to maintain info in confidence).
    
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    Rating Agencies
    
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    Ordinary course of advertising – road shows and stuff.
    

Secondary Liability

Controlling Person Liability

Hollinger v. Titan Cap Corp

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  Wilkowski embezzled money; investors seek to recover their losses from a brokerage firm and a financial counseling firm with which Wilkowski was associated.
  
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  HOLDING: Titan is liable as a controlling person under sec 15 of the 33Act, sec 20(a) of the 34 Act and as Wilkowski’s ER under the common law theory of respondeat superior.
  
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    Sec 15 of the 33 – Every person who controls any person liable under sec 11 or 12, shall also be liable jointly and severally with and to the same extent as such controlled person to any person to whom such controlled person is liable.
    
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    Sec 20(a) of the 34 – Every person who, directly or indirectly, controls any person liable under any provision of this title or of any rule or regulation thereunder shall also be liable jointly and severally with and to the same extent as such controlled person to any person to whom such controlled person is liable
    

ANALYSIS

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  to hold control person liable under sec 20(a) P must first est that def was a controlling person within the meaning of the statute
  
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    P must prove that def exercised “actual power or influence” over Wilkowski’s fraudulent dealings and that def was a “culpable participant” in the alleged illegal activity in order to est that def was a “controlling person” for the purposes of sec 20(a).
    
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      Broker dealer is a controlling person under 20(a) with respect to its registered representatives
      
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      Def is still a controlling person under sec 20(a) even though Wilkowski was an independent contractor  the broker dealer exercises control over its registered representatives bc the representatives need the broker dealer to gain access to the securities market. Broker dealer is required to supervise representatives.
      
  • 
    P is not required to show culpable participation to est that a def was a controlling person under sec 20(a).
    
  • 
    20(a) provides that a controlling person is liable unless he acted in good faith and did not directly or indirectly induce the act or acts constituting the violation or cause of action.
    
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      In an action based on 20a, the def who is a controlling person, and not the P, bears the burden of proof as to def’s good faith. Thus, a P need not make a showing as to def’s culpable participation; rather, a def has the burden of pleading and proving his good faith
      

Basically, once P shows that def is a controlling person, the controlling person has the burden of showing good faith and that they did not directly or indirectly induce the violations.

Proving good faith

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  Under sec 20a - can est the good faith def only by proving that it maintained and enforced a reasonable and proper system of supervision and internal control. Not sufficient for a broker dealer merely to have supervisory procedures in place; the broker dealer must also prove that the supervisory system was diligently enforced.
  
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  Under sec 15, only have to show ignorance, and this is a complete defense.
  
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  My 2 cents – as far as knowledge goes, there might be a thing of imputed knowledge, like in criminal law, if you concerted try to be ignorant, then we’ll hold you knowledgeable. This will work under 20a bc it’s showing a lack of good faith, but what about under sec 15?
  
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  Even if there is good faith shown, fed can still hold the controlling person liable under the doctrine of respondeat superior
  

A lot of courts have applied the following test:

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  to show that the def is a controlling person must show that def
  
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    actively participated in the operations of the corp in general (corp being the primary violator)
    
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    Def possessed the power to control the specific transaction or activity upon which the primary activity was predicated, but it need not be shown that this power be exercised
    

Affirmative Defenses

There are affirmative defenses, but they can only be used when the violation is under their specific act (can only use sec 15 if it’s a 33 act violation)

Sec 15 of the 33 act

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  if it is est that the controlling person had no knowledge or had reasonable ground to believe in the existence of the facts upon which the violation exists  knowledge standard
  

Sec 20a of the 34 act

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  liability arises for a controlling person unless the controlling person acted in good faith and did not directly or indirectly induce the facts that caused the violation
  
  • 
    once you have knowledge, you’re not acting in good faith
    
  • 
    So, maybe, knowledge may be enough to knock out both affirmative defenses
    

Let’s say that you have no knowledge, you can take advantage of sec 15. But, if you don’t have some system in place to monitor, then you may be good under sec 15, but you didn’t act in good faith under 20a.

Aiding and Abetting

Central Bank of Denver v. First Interstate Bank of Denver

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  no longer a fed right of action for aiding and abetting
  
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  Sup ct held that aiding and abetting is no longer a basis for private action under 10b and 10b-5
  
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  Approaches taken by the majority – interpretive methodology
  
  • 
    Aiding and abetting aren’t in the statute – strict constructionist approach.
    
    • 
      When you have an issue of statutory construction, you start with the statutory language
      
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  This case has come up in the context of Enron – aiding and abetting can get all the ancillary players, but it’s hard to get them now in a private class action. We have to show that they were primary violators, which is hard bc now we have to show scienter.
  
  • 
    A number of folks are now saying that this retrenchment of 10b-5 undermines the deterrent effect.
    
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  This coupled with PSLRA really makes it hard to get secondary violators.
  
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